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OF  THE 
SKIVERSnY  OF  UilHOlS 
3 H.9V1914 


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nWJLJH 


FIRE  INSURANCE  RATES  AND 
STATE  REGULATION 


BY 

W.  F.  GEPHART 


4 


REPRINTED  FROM 

The  Quarterly  Journal  of  Economics 
Vol.  XXVIII,  May,  1914 


THE 


QUARTERLY  JOURNAL  OF  ECONOMICS 

Published  by  Harvard  University 

Is  established  for  the  advancement  of  knowledge  by  the  full  and  free  discussion 
of  economic  questions.  The  editors  assume  no  responsibility  for  the  views  of 
contributors , beyond  a guarantee  that  they  have  a good  claim  to  the  attention 
of  well-infor77ied  reade7's. 

Communications  for  the  editors  should  be  addressed  to  the  Quarterly  Journal 
of  Economics , Cambridge , Mass.;  business  communications  and  subscriptions 
($3.00  a year),  to  the  Harvard  University  Press , 2 University  Hall,  Cambridge, 
Mass. 


CONTENTS  FOR  FEBRUARY,  1914 


I.  THE  FEDERAL  RESERVE  ACT  OF  1913 O.  M.  W.  Sprague 

II.  THE  BRITISH  SUPER-TAX  AND  THE  DISTRIBUTION  OF 

INCOME A.  L.  Bowley 

IH.  THE  DEVELOPMENT  BY  COMMISSIONS  OF  THE  PRINCI- 
PLES OF  PUBLIC  UTILITY  VALUATION Ralph  E.  Heilman 

IV.  THE  SOCIAL  POINT  OF  VIEW  IN  ECONOMICS.  II  . L.  H.  Haney 

V.  SOME  ECONOMIC  ASPECTS  OF  THE  NEW  LONG  AND 

SHORT  HAUL  CLAUSE J.  M.  Clark 

VI.  INDUSTRY  IN  PISA  IN  THE  EARLY  FOURTEENTH  CENTURY  F.  C.  Dietz 

VII.  MEDIATION  AND  ARBITRATION  OF  RAILROAD  WAGE  CON- 
TROVERSIES: A YEAR’S  DEVELOPMENT  ....  Fred  Wilbur  Powell 

REVIEW: 

Keynes’  Indian  Currency  and  Finance  E.  W.  Kemmerer 


CONTENTS  FOR  MAY,  1914 


I.  THE  TRUST  PROBLEM  .........  E.  Dana  Durand 

I.  The  Necessity  of  Prohibition  or  Regulation 
n.  The  Possibility  of  Preventing  Combination 

II.  DAVENPORT’S  ECONOMICS  AND  THE  PRESENT  PROB- 
LEMS OF  THEOEY  . Alvin  S.  Johnson 

III.  FIRE  INSURANCE  RATES  AND  STATE  REGULATION  W.  F.  Gephart 

IV.  RENT  UNDER  THE  ASSUMPTION  OF  EXHAUSTEBILITY  . L.  C.  Gray 

V.  HOME  RULE  IN  TAXATION . Horace  Secrist 

VI.  THE  LITERATURE  OF  SCIENTIFIC  MANAGEMENT  . C.  Bertrand  Thompson 

REVIEWS : 

Elsas  ’ Ausnahmetarife Stuart  Daggett 

Bernhard’s  Unerwlinschte  Folgen  der  deutschen  Sozialpolitik  and 

its  Critics Lewis  S.  Gannett 

NOTES  AND  MEMORANDA: 

The  German  Potash  Law  of  1910 H.  R.  Tosdal 

Public  Ownership  of  Telegraphs  and  Telephones  ....  A.  N.  Holcombe 

The  Development  of  Alaska  by  Government  Railroads  . . . Alfred  H.  Brooks 


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yMS'/EHSlTY  OF  ILLINOIS 

3 U0V1914 


FIRE  INSURANCE  RATES  AND  STATE 
REGULATION 


SUMMARY 

I.  Introductory ; peculiarities  as  regards  fire  insurance  rates  in  the 
United  States,  447.  — How  the  price  of  indemnity  differs  from  ordinary 
prices,  448.  — II.  The  theory  of  these  rates,  450.  — Classification  no 
sure  way  of  measuring  hazard,  452.  — Analysis  of  hazard  into  compo- 
nent parts,  453.  — Influence  of  geographical  area,  455.  — III.  Con- 
flagrations a disturbing  factor  in  the  United  States,  457.  — IV.  State 
regulation  of  three  kinds:  (1)  Valued  policy  laws,  458.  — (2)  Anti- 
coinsurance laws,  460.  — (3)  Anti-trust  laws,  462.  — Conclusion,  464. 


I 


Introductory 

Rates  in  fire  insurance,  in  common  with  rates  for 
other  services  which  vitally  affect  the  public,  are  now 
the  subject  for  much  discussion  and  legislation  in  the 
United  States.  The  determination  of  fair  rates  in  fire 
insurance  is  peculiarly  difficult  in  this  country  for  the 
following  reasons:  first,  on  account  of  the  complexity 
r-  _of  the  elements  entering  into  the  cost  of  the  service; 
second,  on  account  of  the  past  and  prospective  presence 
of  conflagrations;  .third,  on  account  of  the  legal  status 
of  insurance  in  the  United  States.  A few  words  of 
introduction  will  serve  to  make  more  clear  these 
peculiarities. 

First,  as  regards  rates  and  cost,  two  methods  of 
determining  fire  insurance  charges  have  been  followed. 
In  the  early  history  of  fire  insurance,  buildings  were 
divided  into  the  two  classes  of  frame  and  brick,  upon 
which  a rate  on  the  basis  of  past  experience  and  per- 


A 


448 


QUARTERLY  JOURNAL  OF  ECONOMICS 


sonal  judgment  was  determined.  In  the  evolution  of 
rate-making,  distinctions  came  to  be  made  between 
classes  of  buildings  within  these  two  general  classes. 
Special  agents,  acting  with  local  agents,  made  all  the 
rates.  Later,  selected  representatives  from  companies 
made  the  rates  for  all  companies  for  a city.  Little 
effort  was  made  to  analyze  the  factors  entering  into 
each  risk.  It  was  a method  of  applying  personal  judg- 
ment and  interpreting  past  experience.  Altho  the  result 
was  in  some  cases  satisfactory,  yet  the  general  disregard 
of  the  good  and  bad  features  in  a particular  risk  did  not 
sufficiently  differentiate  the  particular  risk  from  the 
fictitious  average  risk.  Later  came  the  second  method, 
under  which  various  systems  of  schedule  rating  were 
developed  in  which  an  analysis  of  the  component 
elements  in  the  risk  is  made.  The  application  of  these 
schedule  systems  is  now  very  generally  made  by 
organizations  independent  of  the  insurance  companies. 

Fire  insurance  is  an  indemnity  for  the  whole  or  partial 
loss  of  property,  but  the  cost  of  this  indemnity  cannot 
be  determined  with  accuracy  at  the  time  the  indemnity 
is  sold.  That  is  to  say,  if  the  cost  of  the  service  theory 
should  be  accepted  as  a proper  basis  for  determining 
the  charge,  there  is  no  assurance  that  the  price  charged 
will  be  equal  to  this  cost,  since  so  many  variable  factors 
affect  the  cost. 

Whatever  the  merchant  sells  has  been  bought  in  the 
open  market,  and  his  selling  price  is  ordinarily  deter- 
mined by  adding  the  cost  of  freight,  rent,  clerk  hire, 
fuel  and  light,  together  with  such  profit  as  he  may  regard 
as  adequate.  A manufacturer  buys  his  raw  material 
and  by  adding  cost  of  labor,  operating  expenses,  inter- 
est on  his  plant  and  his  profit  loading,  he  fixes  the  price 
at  which  he  desires  to  sell  his  manufactured  goods.  A 
common  carrier  knows  approximately  what  it  costs  to 


FIRE  INSURANCE  RATES , STATE  REGULATION  449 

transport  passengers  or  merchandise  by  water  or  by 
rail.  Whoever  has  anything  to  sell  attempts  to  fix  in 
advance  the  price  of  what  he  sells  so  that  he  may 
derive  a profit.  But  the  insurer  sells  neither  merchan- 
dise nor  labor ; he  sells  promises  to  pay  in  the  form  of  a 
contract  of  indemnity  against  loss  caused  by  the  hap- 
pening of  an  uncertain  event.  But  when  he  sells  his 
contract  of  insurance  — or  more  properly  speaking  his 
bond  of  indemnity  — he  has  no  means  of  knowing 
whether  he  will  be  called  upon  to  pay  the  stipulated 
indemnity  in  whole  or  in  part. 

Supply  and  demand  do  not  affect  the  price  at  which 
this  indemnity  is  sold  in  the  same  manner  in  which 
supply  and  demand  affect  the  price  of  commodities. 
The  losses  which  occur  after  the  price  is  determined  are 
the  final  determinants  in  fixing  this  price,  and  these 
losses  are  beyond  the  control  of  the  insurer.  In  certain 
cases,  as  in  preferred  risks  upon  which  losses  are  very 
likely  to  be  low,  a condition  of  surplus  of  supply  of 
insurance  may  exist.  This  condition  may  tend  to 
establish  inadequate  rates.  On  the  other  hand  it  may 
happen  that  the  supply  of  insurance  for  other  classes 
of  undesirable  risks  tends  to  be  below  the  demand. 
The  result  is  that  the  forces  of  demand  and  supply  do 
not  establish  that  equilibrium  which  produces  fair 
prices  for  all  classes  of  risks. 

In  the  second  place,  conflagrations  introduce  a very 
large  disturbing  factor  in  any  assumed  system  of  rates 
which  seem  at  the  time  equitable. 

In  the  third  place,  insurance  in  the  UnitecTStates  is  a 
subject  under  the  complete  regulation  of  the  states, 
having  been  declared  neither  commerce  nor  an  instru- 
mentality of  commerce  by  the  United  States  Supreme 
Court.  The  significance  of  this  fact  for  rates  is  that 
there  is  a strong  tendency  on  the  part  of  states  to  estab- 


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lish  the  state  as  the  geographical  unit  for  rate  making 
purposes.  This  may  seriously  prevent  the  proper 
working  of  the  law  of  average,  especially  in  a country 
where  conflagrations  are  yet  common. 

II 

The  Theory  of  Fire  Insurance  Rates 

On  the  part  of  the  public  there  is  very  little  accurate 
knowledge  as  to  the  nature  and  purpose  of  fire  insurance. 
The  average  person  considers  it  in  much  the  same  light 
as  he  does  any  common  subject  of  sale  and  purchase. 
He  assumes  that  he  may  go  into  the  market  and  pur- 
chase as  much  or  as  little  as  he  chooses  at  so  much  per 
unit  of  measurement.  He  confuses  it  with  life  insurance, 
concerning  which  he  has  gained  considerable  knowledge 
during  the  last  decade.  He  purchases  as  much  life 
insurance  as  his  saving  power  enables  him.  But  fire 
insurance  has  no  direct  relation  to  saving,  but  is  always 
a question  of  indemnity  for  property  loss.  The  individ- 
ual demand  cannot  be  measured  in  fire  insurance  by  the 
ability  and  desire  to  purchase,  but  must  be  limited  by 
the  value  of  property  possessed;  whereas  in  life  insur- 
ance full  operation  of  effective  individual  demand  may 
be  permitted,  except  as  it  is  limited  by  the  physical 
condition  of  the  applicant,  or  a maximum  limit  of 
insurance  in  a particular  company.  That  is  to  say,  an 
individual  in  normal  health  could  purchase  without 
injury  to  the  business  or  to  other  people  all  the  life 
insurance  he  desired;  but  the  amount  of  fire  insurance 
which  he  should  be  permitted  to  purchase  is  limited  by 
the  value  of  his  property. 

The  simplest  statement  of  the  theory  of  fire  insurance 
rates  is  that  the  rate  is  a resultant  of  the  property  loss, 
the  expense  element,  the  maintenance  of  the  reserve 


FIRE  INSURANCE  RATES,  STATE  REGULATION  451 

required  by  the  various  state  law^  and  a provision  for  a 
return  on  the  capital  invested.  The  interest  rate  is 
over  considerable  periods  of  time  a relatively  constant 
factor.  It  is  the  property  loss  element  in  the  final  cost 
which  fluctuates.  This  property  loss  is  for  any  one 
year  an  indeterminate  and  largely  an  independent 
variable.  The  burning  rate  is  always  in  process  of 
change,  and  the  range  of  it  on  an  annual  basis  is  some- 
times very  great.  The  fluctuation  for  a year  in  the 
total  loss  ratio  may  vary  as  much  as  20  %,  and  the  loss 
ratio  on  particular  kinds  of  property,  or  upon  all  classes 
of  property  in  particular  regions,  may  vary  much  more. 
Yet  rates  for  the  future  — since  fire  insurance  is  a ser- 
vice sold  for  future  delivery  — must  be  determined. 
The  only  correct  method  is  an  analysis  of  the  numerous 
hazards  which  make  up  the  fire  loss.  Past  experience 
must,  therefore,  play  a large  part  in  supplying  a basis 
for  this  analysis.  The  true  measurement  of  fire  hazard 
is  the  placing  of  every  risk  in  its  proper  relative  position, 
and  while  this  position  of  relativity  may  change  from 
year  to  year,  yet  each  factor  contributing  to  the  hazard 
should,  so  far  as  is  possible,  be  in  the  proper  relation  to 
the  total  charge. 

It  is  a common  doctrine  in  determining  prices  that 
each  product  should  bear  its  total  costs  of  production. 
Since  insurance  is  an  element  in  the  total  costs  of  pro- 
ducing a product,  it  is  assumed  by  many  that  industries 
should  be  classified  as  the  only  method  of  assessing  this 
cost  of  insurance.  There  is  also  another  aspect  to 
classification,  namely,  that  the  class  should  be  limited 
to  the  property  in  a particular  state.  Both  these 
ideas  contain  elements  of  danger  as  well  as  impractica- 
bility. If  the  first  idea  means  that  a particular  business, 
as  for  example  drug  stores,  should  be  placed  in  one  class, 
for  purposes  of  determining  the  insurance  charge,  the 


452 


QUARTERLY  JOURNAL  OF  ECONOMICS 


contention  cannot  be  supported  either  on  grounds  of 
theory  or  practicability.  It  is  true  that  classification 
has  some  value  in  arriving  at  insurance  costs.  Experi- 
ence of  losses  on  classes  of  property  may  aid  in  deciding 
upon  base  rates  to  which  the  more  completely  analyzed 
elements  in  the  risk  may  be  added  in  arriving  at  the 
final  rate.  Then,  too,  certain  kinds  of  property  have 
not  had  a system  of  schedule  rating  worked  out  for 
them;  nor  is  it  important  to  apply  a minutely  analyzed 
system  to  those  kinds  of  property,  as,  for  example, 
dwelling  houses,  which  have  a large  degree  of  uniformity. 
In  such  cases,  rates  based  upon  the  general  experience 
of  such  classes  of  property  may  when  properly  applied 
have  no  territorial,  personal,  or  property  discrimination 
in  them. 

It  can  be  accepted  as  true  and  desirable  that  each 
product  should  express  in  its  selling  price  its  total  costs 
of  production,  but  the  insurance  element  entering  into 
the  price  of  the  product  can  be  determined  in  a more 
accurate  manner  than  by  mere  classification.  What  is 
sought  to  be  measured  is  the  degree  of  likeness  or  the 
amount  of  sameness  in  the  quantity  of  the  hazard  in  the 
individual  risks.  Fire  hazard  is  not  as  a totality 
inherent  in  the  property  itself.  It  is  made  up  of  inter- 
nal and  external  elements,  as  well  as  intangible  factors. 
These  may  be  enumerated:  the  character  of  the  con- 
struction material;  the  character  of  the  occupancy;  the 
manner  or  use  of  the  occupancy;  the  character  of  the 
surroundings,  or  the  exposure;  and,  finally,  the  char- 
acter of  the  owner  or  occupier  of  the  buildings.  This 
last  factor  in  the  hazard  is  known  as  the  moral  hazard 
and  manifestly  is  difficult  to  appraise  in  its  true  bearing 
on  the  fire  rate.  It  follows,  therefore,  that  all  drug 
stores,  or  all  wholesale  dry  goods  establishments  cannot 
be  said  to  have  a unit,  unchangeable  expression  of  their 


FIRE  INSURANCE  RATES,  STATE  REGULATION  453 

hazard.  A wooden  drug  store  in  an  outlying  district 
may  have  quite  as  low  a hazard  as  a brick  one  in  a con- 
gested district,  or  a hardware  establishment  may  be 
equal  in  its  hazard  to  some  one  dry  goods  establishment. 

If  the  hazard  of  two  risks  of  a certain  class,  as  for 
example  drug  stores,  is  approximately  the  same,  this  is 
a matter  of  accident.  It  is  quite  as  possible  that  the 
difference  in  the  amount  of  hazard  of  two  such  risks  will 
be  greater  than  the  difference  in  hazard  between  one  of 
these  risks  and  a risk  in  an  entirely  different  business. 
It  is,  therefore,  the  elements  that  go  to  make  up  the 
hazard  which  should  be  the  starting  point  of  analysis 
and  not  the  class  of  risks  themselves.  Nor  would  such 
a method  of  procedure  vitiate  the  economic  principle 
that  each  product  should  bear  its  total  costs  of  produc- 
tion. Indeed  it  will  most  readily  and  accurately  deter- 
mine its  true  total  costs.  Nor  is  the  least  significant 
result  of  such  a method  of  determining  insurance  costs 
that  it  will  have  a powerful  effect  in  reducing  the 
unnecessarily  high  losses  by  fire  in  the  United  States. 
The  total  hazard  thus  determined  of  each  risk  is  com- 
posed of  numerous  elements.  Each  factor  in  the  build- 
ing contributes  to  the  hazard  or  reduces  it,  and  each 
property  owner  knows  how  to  reduce  his  rate  by 
improving  the  condition  of  his  property.  The  method 
also  establishes  a time  basis  for  classification.  Public 
officials  supervising  insurance  then  have  a basis  upon 
which  to  decide  the  equity  of  rates  among  classes  of 
property.  Like  hazards  should  bear  like  rates,  but  the 
similarity  of  hazards  cannot  be  determined  from  the 
starting  point  of  the  particular  business  classified 
according  to  its  product. 

Confusion  often  arises  in  this  particular  by  an  unwar- 
ranted assumption  of  similarity  between  fire  and  life 
insurance  rates.  The  chief  elements  of  the  risk  in  life 


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insurance  are  found  in  the  mortality  rate  and  the  invest- 
ment rate.  The  burning  rate  in  fire  insurance  corre- 
sponds, so  far  as  there  is  any  correspondence,  to  the 
mortality  rate  in  life  insurance.  There  is,  however, 
greater  homogeneity  among  insured  lives  than  among 
insured  property.  In  life  insurance,  a selection  of 
normal  lives  has  been  made  by  the  medical  examination, 
and  while  these  lives  lend  themselves  to  certain  classifi- 
cations upon  the  basis  of  sex  and  age,  and  while  experi- 
ence of  each  insured  group  shows  certain  variations 
from  the  assured  rate  of  mortality,  yet  this  original 
selection  of  normal  lives  assures  a large  degree  of 
homogeneity  in  the  group.  In  fire  insurance  there  are 
many  kinds  of  property,  differing  not  only  as  to  con- 
struction but  also  as  to  the  particular  use  made  of  it  and 
the  protection  from  fire  about  it.  Heterogeneity,  not 
homogeneity,  is  the  characteristic  of  the  fire  insurance 
risk. 

The  basic  principle  which  is  the  foundation  of  equi- 
table rating  between  persons  and  fair  rates  to  the  public 
is  then  the  analysis  of  a hazard  into  its  component  parts. 
There  is  thus  established  a standard  for  each  part  and  a 
scale  of  charges  and  credits  for  any  deviation  from  this 
standard.  Under  a developed  system  of  schedule 
rating,  a rate  is  made  up  of  plus  and  minus  elements, 
and  a true  basis  of  classification  is  thus  supplied.  It 
must  be  admitted  that  such  a method  of  measurement 
is  not  absolutely  complete.  There  is  in  the  system  of 
schedule  rating  a basis  rate  which  is  said  to  represent  the 
unanalyzable  elements  in  the  hazard,  or  the  residuum 
of  hazard.  But  this  is  not  a vital  objection.  The 
method  is  infinitely  superior  to  a rough  and  ready  one 
of  assessing  fire  charges  on  the  experience  of  past 
years  or  series  of  years,  either  by  the  officials  of  the 
company  for  the  whole  country,  or  by  groups  of 


FIRE  INSURANCE  RATES,  STATE  REGULATION  455 

companies’  agents  for  a particular  territory.  It  must 
also  be  recognized  that  the  public  could  not  and  does 
not  demand  such  nicety  in  the  analysis  of  other  total 
costs  of  products  in  order  to  justify  the  demanded 
price  from  the  sellers  of  products  and  services.  It  is 
only  recently  that  the  demand  has  been  made  upon 
railways  for  a justification  of  their  demanded  price. 
These  rating  schedules  are  being  continually  improved 
and  must  commend  themselves  increasingly  to  the 
public  and  its  insurance  supervisors. 

Granting  that  such  a theory  of  determining  rates 
should  be  accepted,  the  problem  is  not  yet  solved, 
because  it  leaves  out  of  consideration  the  geographical 
area  upon  which  the  experience  should  be  based.  In 
pure  theory,  an  analysis  of  the  fire  hazard  of  a state  or 
any  other  local  political  area  would  arrive  at  the  exact 
cost  of  the  fire  protection;  but  it  would  not  be  insur- 
ance. True  insurance  is  not  only  a calculation  of  a 
risk  but  a distribution  of  it.  The  area  of  distribution 
must  be  sufficiently  wide  to  make  the  burden  of  cost 
upon  each  less  than  he  would  bear  as  an  individual. 
The  single  risk,  or  even  a limited  number  of  risks  made 
into  a class,  as  might  be  true  in  a single  state,  is  a risk 
with  no  insurance. 

Every  purchaser  of  insurance  should  benefit  from 
distribution,  and  the  rarity  of  his  risk  or  the  size  of  it 
ought  not  to  interfere  with  this  privilege  of  a broad 
distribution.  The  rate  for  the  particular  individual 
may  be  ten  times  as  great  as  the  average  rate  for  the 
country  or  even  higher  than  the  average  rate  for  the 
class  in  which  he  is  located;  but  his  rate  still  is  lower 
because  he  belongs  to  a group  whose  rates  are  based 
upon  a wide  distribution. 

If  a state  should  insist,  as  undoubtedly  it  has  the 
legal  power  so  to  do,  that  rates  should  be  based  upon 


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the  actual  experience  within  the  state,  it  must  realize 
that  this  may  mean  very  heavy  burdens,  and  so  long  as 
conflagrations  are  prevalent,  impossible  burdens.  It 
could  not  claim  the  exclusive  state  benefits  of  years  of 
low  rates  within  the  State,  and  then  when  heavy  losses 
occur,  transfer  its  rates  to  a national  basis.  If,  in  a 
selfish  manner,  it  refused  to  consider  national  losses  in 
making  its  state  rates,  it  would  have  little  ground  in 
morals  to  expect  assistance  at  the  time  of  a heavy  loss 
within  the  state,  and  even  less  good  grounds  to  increase 
rates  upon  all  property  within  the  state  after  the  heavy 
loss  occurred.  There  is  little  reason  to  argue  for  a 
community  of  state  interests  in  this  respect  as  con- 
trasted with  the  community  of  national  interest.  It 
does  not  follow  that  a state  which  has  by  careful 
supervision  over  fire  losses,  good  building  codes,  fire 
prevention  devices,  and  other  measures  reduced  the 
fire  loss  will  be  penalized  by  the  carelessness  of  other 
communities.  The  system  of  analyzing  the  amount  of 
fire  hazard  by  its  credit  and  debit  items  removes  this 
objection. 

The  aggregate  premium  collected  constitutes  a fund 
from  which  all  losses  and  expenses  must  be  paid,  and  a 
sum  set  aside  each  year  to  constitute  the  unearned 
premium  reserve.  This  unearned  premium  is  a sum 
held  in  trust  by  the  company  for  its  policy-holders. 
It  represents  that  portion  of  the  protection  paid  for, 
but  not  yet  earned.  After  these  sums  are  deducted 
from  the  aggregate  premium,  the  remainder  constitutes 
the  “ underwriting  profit.”  This  balance  includes  both 
interest  and  profit.  Some  years  show  an  underwriting 
profit  and  some  years  a loss.  During  any  one  year, 
some  companies  show  a larger  profit  than  the  average 
profit,  and  in  some  cases  no  profit  at  all  for  the  year. 
No  one  year  nor  any  one  company  affords  a basis  upon 


FIRE  INSURANCE  RATES,  STATE  REGULATION  457 

which  to  reach  a conclusion  either  as  to  profitableness 
of  fire  insurance,  or  as  to  the  proper  rates  for  the  suc- 
ceeding year.  For  example,  the  underwriting  profit 
for  the  past  several  decades  in  fire  insurance  has  been 
negligible.  Whether  the  expenses  are  too  high,  or 
whether  the  rates  are  insufficient,  are  entirely  different 
questions. 

Ill 

Conflagrations 

Conflagrations,  from  which  most  European  countries 
are  free,  are  a very  disturbing  factor  in  making  fire 
insurance  rates  in  this  country.  The  general  absence 
of  conflagrations  in  Europe  as  compared  to  the  United 
States  is  due  to  the  following  causes:  difference  in  the 
character  of  the  construction  material;  difference  in  the 
building  codes;  difference  in  laws  referring  to  the  use  of 
buildings  and  the  occurrence  of  fires. 

Our  strong  individualism,  as  well  as  the  economic 
interest  involved,  has  made  us  unwilling  to  submit 
either  to  strict  regulations  governing  the  construction 
and  use  of  buildings,  or  to  the  inquisitorial  methods 
often  followed  in  order  to  determine  responsibility 
when  a fire  occurs  in  many  European  countries.  We 
have  believed  it  has  been  cheaper  to  build  and  burn, 
then  build  again,  than  to  build  substantially.  If  a 
tepant  or  occupier  were  brought  before  a magistrate  to 
show  cause  why  he  should  not  be  penalized  for  permit- 
ting a fire  to  occur  in  a building,  the  average  citizen’s 
most  cherished  ideas  of  liberty  and  freedom  would  be 
violated.  Yet  a fire  in  any  city  is  not  a private  matter. 
The  public  interest  involved  becomes  more  apparent 
with  the  growth  of  cities  and  the  enormous  losses  result- 
ing from  recurrent  conflagrations. 


458 


QUARTERLY  JOURNAL  OF  ECONOMICS 


No  other  factor  suggests  so  strong  an  argument 
against  the  practicability  of  making  rates  upon  the 
experience  of  a particular  state,  whatever  may  be  the 
additional  weakness  of  the  plan  on  purely  theoretical 
grounds.  The  frequent  disposition  of  the  uninformed 
to  quote  the  practice  of  European  cities  in  this  respect 
proves  nothing  when  applied  to  the  United  States.  It 
is  doubtless  true  that  the  officials  of  the  companies  have 
in  the  past  distributed  this  conflagration  loss  by  crude 
methods,  but  distributed  it  has  been.  It  is  very 
questionable  if  the  states  will  be  willing  to  provide  for 
this  conflagration  loss,  either  if  they  make  or  closely 
supervise  the  rates.  The  citizens  may  readily  admit  the 
justice  and  necessity  of  distributing  the  loss  after  a 
conflagration  occurs  in  their  own  state,  but  not  a small 
portion  of  the  late  criticism  against  fire  rates  has  arisen 
as  a result  of  the  distribution  (in  part)  of  the  heavy 
losses  due  to  the  San  Francisco  and  Baltimore  fires. 

IV 

State  Legislation 

There  remain  to  be  considered  some  of  the  important 
characteristics  in  the  practice  of  rates  as  affected  by 
state  statutes.  There  are  laws  of  three  sorts  in  force 
in  many  of  the  states,  which  may  be  taken  as  an  expres- 
sion of  what  rates  should  be  in  practice  according  to  the 
legislators,  as  compared  to  what  they  should  be  in 
theory.  These  laws  are  the  valued  policy  law,  the 
anti-coinsurance  law,  and  the  anti-compact  law. 

(1)  The^  valued  policy  law  is  in  brief  that  the  value 
expressed  in  the  policy  shall  be  taken  as  the  true  basis 
of  settlement.  The  company  must  pay  the  sum  stated 
in  the  policy.  This  would  seem  upon  first  considera- 
tion to  be  quite  proper,  since  in  a contractual  relation- 


FIRE  INSURANCE  RATES,  STATE  REGULATION  459 

ship  between  two  parties  there  should  be  no  doubt 
concerning  the  principal  thing  to  be  delivered.  But  a 
fire  insurance  contract  is  a personal  contract  of  indem- 
nity. The  value  of  property  is  continually  changing, 
and  it  is  not  always  an  easy  matter  for  the  insurance 
company  to  determine  the  original  value  of  the  property, 
to  say  nothing  of  its  changing  values.  This  would 
involve  a very  large  expense  for  inspection.  The  insurer 
must  expect  the  utmost  good  faith  on  the  part  of  the 
insured  in  making  the  contract.  Again,  it  is  another 
fundamental  characteristic  of  all  insurance  that  the 
insured  shall  in  no  way  gain  or  make  a profit  from  the 
insurance  contract.  It  therefore  happens  that  in 
those  states  where  such  a law  is  in  force  an  inducement 
is  offered  to  over-value  property  and  also  an  inducement 
to  be  careless  in  the  use  of  the  property.  Evidence  is 
not  wanting  that  a number  of  cases  of  wilful  destruction 
occur  every  year  and  during  the  time  of  an  industrial 
depression  the  number  of  such  cases  increases. 

The  legislator  and  the  public,  in  enacting  valued 
policy  laws,  directed  their  attention  solely  to  the  condi- 
tions at  the  end  of  the  contract,  that  is,  when  the  fire 
occurred.  They  desired  to  be  assured  that  the  loss  in 
full  would  be  paid,  and  doubtless  the  practice  of  some 
companies  in  evading  payment  for  losses  is  largely 
responsible  for  these  laws.  Yet  no  honestly-managed 
company  has  any  objections  to  paying  the  full  indem- 
nity. The  means  used  to  correct  an  injustice  suffered 
by  some  property  owners  have  not  worked  to  the  advan- 
tage either  of  the  insured  or  insurer.  If  legislators  had 
considered  the  conditions  of  the  fire  insurance  contract 
as  a whole,  and  not  the  conditions  at  the  termination 
of  it,  they  would  have  recognized  that  valued  policy 
laws  increased  the  cost  of  insurance  in  two  ways. 
First,  there  is  the  added  expense  of  appraising  the 


460 


QUARTERLY  JOURNAL  OF  ECONOMICS 


property  in  order  to  avoid  over-insurance.  This 
expense  must  be  borne  by  policy  holders.  It  must  be 
remembered  that  but  a small  per  cent  of  insured  prop- 
erty is  destroyed,  and  the  additional  appraisal  expense 
is  borne  by  all  for  the  sake  of  the  few  whose  property 
burns.  Second,  in  the  actual  working  of  the  law, 
appraisals  are  often  not  made  carefully,  and  many 
property  owners  are  able  to  secure  insurance  in  excess 
of  the  value  of  the  property.  This  means  that  the 
honest  property  holder  who  insures  his  property  has  an 
additional  charge  levied  upon  him  by  the  dishonest 
property  holder,  who  thus  uses  insurance  as  a source 
of  gain  and  not  as  a means  of  indemnification. 

The  insurance  charge  in  this  respect  resembles  a tax. 
If  the  rate  of  taxation  is  determined  upon  the  true  value 
or  any  specific  percentage  value  of  the  property,  it  is 
essential  for  equity  in  payments  that  each  shall  return 
this  value  of  the  property.  If  any  one  person  does  not 
do  so,  the  remainder  will  be  compelled  to  bear  so  much 
more  tax,  since  a certain  sum  of  money  must  be  raised. 
Similarly,  if  an  individual  collects  $1000  more  fire 
insurance  than  his  true  loss,  this  sum  must  come  from 
the  premiums  of  others.  Fire  insurance  is  not  a com- 
modity, like  wheat,  which  can  be  sold  at  a certain  price 
per  unit  and  which  can  be  purchased  in  any  quantity 
by  any  buyer  without  doing  an  injury  to  other  buyers. 
No  great  public  injury  is  suffered  when  an  individual 
purchases  ten  bushels  of  wheat  when  he  needed  only 
five  bushels.  But  the  same  individual  cannot  purchase 
$1000  worth  of  insurance  when  he  needs  only  $500 
worth  without  doing  an  injury  to  all  other  purchasers 
of  insurance. 

(2)  Coinsurance  is  a method  under  which  the  prop- 
erty owner  has  his  losses  paid  only  in  the  proportion 
that  the  amount  of  the  insurance  he  purchases  bears 


FIRE  INSURANCE  RATES,  STATE  REGULATION  461 

to  the  amount  of  the  insurance  which  the  company 
normally  expects  or  requires  him  to  buy.  That  is  to 
say,  he  becomes  a coinsurer  for  himself  with  the 
company, 

The  anti-coinsurance  law  is,  therefore,  one  which 
prohibits  an  insurance  contract  from  containing  a 
clause  which  makes  the  insured  an  insurer  with  the 
company  in  case  his  property  is  not  insured  to  a certain 
per  cent  of  its  value.  It  is  just  as  important  that 
property  be  not  under-insured  as  that  it  be  not 
over-insured.  To  prohibit  such  a clause  is  to  make 
impossible  the  measurement  of  fire  hazard  and  the 
apportionment  of  it.  There  must  be  some  one  uniform 
ratio  of  insurance  to  value.  It  makes  no  very  great 
difference  what  this  ratio  is.  In  practice  it  has  become 
80  per  cent.  Some  property,  however,  cannot  be 
insured  at  20  per  cent  of  its  value  and  other  property 
at  80  per  cent  of  its  value,  if  the  charge  is  to  be 
equitably  apportioned. 

The  prevalence  of  such  a law  has  worked  great 
injustice  to  small  property  holders  in  favor  of  owners  of 
large  and  diverse  property.  The  owner  of  the  shop, 
the  store,  or  the  farm  is  prompted  by  his  own  interest 
to  insure  his  property  for  a sum  near  to  its  true  value, 
since  the  loss  of  it  means  much  to  him.  But  the  owners 
of  large  and  distributed  manufacturing  property,  or 
large  mercantile  properties,  and  other  properties  which 
are  frequently  housed  in  fireproof  and  separated  build- 
ings, and  in  cities  with  good  water  and  fire  department 
protection  has  no  such  inducement.  The  losses  of  the 
latter  are  likely  to  be  only  partial,  and  a small  amount 
of  insurance  gives  a large  amount  of  protection.  Insur- 
ance for  30  per  cent  of  the  value  of  the  property  may  in 
the  latter  case  protect  as  well  as  80  per  cent  of  the  value 
of  the  property  in  the  former  case.  It  is  desirable  that 


462  QUARTERLY  JOURNAL  OF  ECONOMICS 

the  owners  should  each  insure  to  the  same  value,  and 
in  case  a class  of  owners  do  not,  they  should  become 
coinsurers  with  the  insurer  for  the  difference  in  value 
between  the  insured  value  and  the  stated  basis,  as  for 
example,  80  per  cent.  There  is  no  other  one  cause  of  so 
much  discrimination  as  the  practices  encouraged  by 
these  anti-coinsurance  laws. 

It  must  be  understood  that  a coinsurance  clause  has 
no  effect  upon  the  amount  due  to  the  insured  in  the 
event  of  a loss,  large  or  small,  if  the  amount  of  insurance 
carried  by  him  equals  or  exceeds  the  percentage  of  the 
whole  value  of  the  property  insured  which  the  coinsur- 
ance clause  requires.  The  clause  is  of  no  effect  when 
there  is  a complete  loss,  or  when  the  damage  equals  or 
exceeds  the  percentage  of  the  total  value  insured  which 
is  stipulated  in  the  coinsurance  clause.  It  is  only  when 
there  is  a partial  loss  which  destroys  a smaller  percen- 
tage of  the  value  of  the  property  than  that  stated  in  the 
coinsurance  clause.  The  importance  of  the  clause  is 
increased  by  the  fact  that  the  greater  number  of  losses 
are  partial  losses.  The  relation  of  this  anti-coinsurance 
law  to  the  valued  policy  law  is  important.  The 
practical  operation  of  the  former  law  is  to  encourage 
the  under-insurance  of  property.  In  either  case  the 
cost  of  insurance  is  increased,  and  inequitable  rates  as 
regards  different  states  and  different  individuals  in  the 
same  state  result. 

(3)  The  third  set  of  laws  which  illustrate  the  dif- 
ference between  insurance  rates  in  theory  and  practice 
isj^unti-compact  laws.  These  laws  are  very  common 
in  the  insurance  legislation. mf  the  States.  In  brief 
they  prohibit  the  companies  from  agreeing  upon  uni- 
form rates.  They  express  the  firm  conviction  on  the 
part  of  many  people  that  competition  is  always  desir- 
able. It  is  assumed  that  any  evidence  of  a uniformity 


FIRE  INSURANCE  RATES,  STATE  REGULATION  463 

in  charges  for  goods  or  service  is  proof  of  monopoly. 
It  is  not  recognized  that  the  companies  have  little 
control  over  the  chief  element  in  the  cost  of  the  service, 
that  is,  the  burning  rate. 

There  are  two  other  elements  in  the  cost  of  the  service 
besides  the  burning  rate,  viz.,  the  expense  element  and 
the  investment  return.  Over  the  expense  element 
the  company  does  have  some  control;  but  it  has  very 
little  control  over  the  element  of  investment.  The 
interest  rate  is  largely  independent  of  the  companies. 
Thus  two  of  the  three  factors  which  finally  determine 
the  rate  of  charge  are  largely  independent  of  particular 
company  influence.  Nevertheless,  competition  has 
sought  to  be  enforced  by  prohibiting  companies  from 
acting  jointly  in  the  measurement  of  fire  hazard,  and 
agreeing  upon  a common  basis  of  rates.  Reckless 
operation  has  thus  been  encouraged  on  the  part  of 
some  companies.  Rate  wars  have  occurred.  Large 
fluctuations  in  rates  have  been  common.  Doubtless 
many  individuals  have  benefited  at  these  times  of  rate 
wars  by  securing  a lower  rate.  But  the  practise  has  also 
made  possible  discrimination  between  the  large  prop- 
erty holder  who  could  bargain  more  successfully,  thus 
defeating  the  assumed  purpose  of  anti-trust  laws.  Not 
least,  such  laws  have  failed  to  reduce  the  fire  loss. 

Notwithstanding  the  numerous  laws  which  have  been 
enacted  in  different  states  to  prevent  monopoly,  the 
evidence  against  the  existence  of  monopoly  in  fire 
insurance  is  undoubted.  The  late  realization  of  the 
potential  danger  of  monopoly,  due  to  disclosures  of 
evils  experienced,  has  made  the  public  super-sensitive 
and  lacking  in  discrimination  as  to  evidence  of  monop- 
oly. Some  states  have  enacted  anti-trust  laws  under 
which  insurance  companies  could  be  prosecuted  for  the 
most  trivial  agreement  in  regard  to  methods  of  con- 


464  QUARTERLY  JOURNAL  OF  ECONOMICS 

ducting  the  business.  Missouri  passed  a law  which 
stated  that  the  use  by  two  companies  of  the  same 
schedule  of  rates  should  constitute  a violation  of  the 
anti-trust  law,  notwithstanding  that  these  schedules 
were  made  by  an  independent  organization  not  engaged 
in  the  insurance  business.  The  companies  generally 
prepared  to  withdraw  from  the  state,  when  they  were 
informed  that  this  agreement  to  withdraw  was  also  a 
violation  of  the  anti-trust  law.  It  was  finally  agreed 
that  the  law  should  not  be  enforced,  pending  an  investi- 
gation of  the  whole  subject  of  fire  insurance  by  a special 
commission. 

In  those  states  and  countries  where  no  anti-compact 
laws  are  in  force,  there  is  no  real  evidence  of  monopoly. 
New  companies  are  organized.  There  is  at  present  the 
greatest  need  to  compel  companies  to  agree  upon  rates 
and  to  enforce  an  adherence  to  such  rates,  derived  from 
past  experience  and  a proper  analysis  of  fire  hazard. 
Nor  would  such  an  enforced  agreement  mean  that  the 
fire  charge  would  be  stationary,  nor  that  approval 
would  be  given  to  a stated  expense  element  in  the  final 
charge.  Each  company  would  have  an  inducement  to 
practise  economy  in  expense,  and  to  increase  its  effi- 
ciency in  whatever  manner  this  was  possible.  The 
price  of  the  service  under  such  conditions  would  be  a 
reflection  of  the  most  efficient  producing  unit. 

The  state  might,  theoretically,  make  just  as  scientific 
rates  as  is  now  done  by  private  organizations  and  the 
companies,  but  those  who  argue  for  the  assumption  of 
such  a function  by  the  state  should  be  able  to  answer 
clearly  two  questions:  First,  what  are  the  grounds  for 
the  state’s  thus  invading  the  field  of  private  business  ? 
What  is  the  nature  of  the  public  injury  threatened 
which  under  our  theory  of  government  would  justify 
this  extension  of  its  functions  ? Second,  what  assur- 


FIRE  INSURANCE  RATES , STATE  REGULATION  465 

ance  can  be  given  that  under  such  a system  due  con- 
sideration will  be  given  to  that  wider  basis  of  rating 
which  is  necessary  to  secure  fair  rates  for  all  ? Would 
not  state  interest  demand  that  undue  consideration  be 
given  fire  losses  in  the  particular  state  ? 

Further,  since  insurance  is  so  completely  a subject  for 
state  regulation,  it  may  be  asked  what  can  be  gained 
by  a system  of  state  rating  which  could  not  equally 
as  well  be  secured  by  a proper  supervision  of  rating. 

Summing  up,  we  may  say  that  the  public  is  pri- 
marily interested  in  the  fire  insurance  contract  in  order 
to  assure  the  buyer  of  insurance  that  the  seller  is  able 
to  fulfill  his  part  of  the  contract.  This  interest  is 
peculiarly  justified  by  the  fact  that  the  buyer  has  no 
satisfactory  means  of  determining  the  solvency  of  the 
insurance  company.  The  thing  sold,  that  is,  indemnity, 
has  no  tangible  expression  by  which  the  buyer  can 
judge  its  quality.  This  fact  is  also  the  basis  for  the 
present  agitation  for  the  enactment  of  laws  which  will 
give  to  a public  official  the  power  to  supervise  the 
organization  of  companies,  the  sale  of  their  stock,  and 
their  liquidation  in  case  of  insolvency.  The  state  may 
also  properly  supervise  rates  in  order  to  secure  equitable 
charges  for  all  purchasers  of  insurance.  The  working 
of  competition  will  probably  prevent  excessive  returns 
for  the  service  rendered  as  a whole,  but  it  cannot  pre- 
vent discrimination  between  individuals  and  classes  of 
property. 

W.  F.  Gephart. 

Washington  University, 

St.  Louis,  Mo. 


. 


J 


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